Prosper Adjusts Interest Rates on Repeat Borrowers

Regular readers of this blog will know how much I like the repeat borrower segment of p2p lending. Only officially available on Prosper, this has been one of the best performing segments of borrowers in all of p2p lending, and it happens to be where I focus most of my Prosper investments.

To be clear, when I talk about previous borrowers I am referring to those borrowers who have successfully been issued with a loan on Prosper, are in good standing on that loan, and are now looking to apply for a new loan. Their previous loan may or not have been fully paid off. Prosper allows borrowers to create a second loan listing within 6-12 months as long as certain conditions are met.

Lower Interest Rates for Borrowers, Higher Returns For P2P Investors

On Friday of last week, in this detailed blog post, Prosper announced they are adjusting the interest rates on repeat borrowers. At the same time they are making adjustments to their proprietary Prosper ratings system that will mean many repeat borrowers will jump a loan grade, say from Grade D to Grade C. This will mean lower interest rates for these borrowers.

At the same time Prosper has recalculated their all-important expected loss rates so in effect these interest rate changes will result in a higher expected return for investors. For example, D-rated repeat loans will now receive an expected 13.63% return going forward versus a 12.43% before. But D-grade borrowers will now be offered a 25.74% interest rate versus 30.99% rate before (because these borrowers were an E-grade before).

If this works out the way Prosper expects this is great news for investors and repeat borrowers. My biggest complaint about repeat borrowers is that there are not enough of them. With my strict filtering criteria I only find 4-6 loans a week to invest in and I would like to see many more loans. Hopefully, this change will increase the number of available loans that meet my criteria while maintaining the high ROI on these loans.

No More Repeat Borrowers with HR Grade

The interesting part is that interest rates have not dropped across the board. In fact, some interest rates for previous borrowers have increased slightly. But with the changing calculation for assigning a loan grade it will mean reduced rates for most repeat borrowers.

Also, along with this change repeat borrowers with an HR rating are no longer allowed. The reason for this seems to be that eligible borrowers that would have had an HR rating will now be classified with an E rating.

Why Previous Borrowers on Prosper Are So Good

You just need to look at the data on Lendstats to appreciate previous borrower loans. Looking at Prosper 2.0 loans (those originated from July 2009 onwards) Lendstats has an estimated ROI on all loans (as of today) at 9.33%. When looking at all previous borrower loans that estimated ROI jumps to 13.14%, almost four full percentage points.

When you look at the risker loan grades this difference is even greater. All D,E and HR loan grades on Prosper 2.0 are returning an estimated ROI of 11.93% at Lendstats. When looking at just previous borrower loans in those grades the estimated ROI jumps to 16.95% or more than five percentage points higher. Clearly this is a very good performing segment and one that has probably been overpriced for some time.

My Own Experience with Previous Borrowers

I started investing in previous borrower loans almost exclusively on Prosper about six months ago. My average age of these loans in my portfolio is just 4.5 months so I know these loans are still very young. But the thing that has amazed me about my previous borrower loans is that they are all still current. There is not one late loan among the 81 loans that I have invested in. And I am investing in only the risker loans – those loans rated D, E and HR with an interest rate of more than 20%.

I have invested in these loans expecting a default rate of more than 10%. Of course, maybe I will end up seeing defaults close to this number but when I look at my own portfolio on Prosper and see every single loan current I am very pleasantly surprised to say the least.

These changes in borrower ratings and interest rates are quite complicated and I don’t really have the space here to cover it fully. I highly recommend that investors read the PDF file Prosper released that contains a thorough explanation of these changes.

It will be very interesting to see how these changes play out a few months and years from now. What do other Prosper investors think? Is this a good move by Prosper? I am always interested to hear your thoughts.

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Comments

My intuition was that these loans were going to exceed Prosper’s profit expectations. While I’ll be sad to see this extra profitable segment of the business have its rates decreased to a more standard profit level, it should encourage responsible borrowers to return to Prosper in the future.

Make no mistake, this move is 100% for the borrower. The rest is just smoke & mirrors & spin. It makes a lot of sense to do this since loan originations are where 90%+ of the money is made in p2p. Assuming the Prosper average 36 month term, $6k loan………….the average repeat borrower saves roughly $15-16 from their monthly payment.

The smoke & mirror & spin part is to suggest that the investor also benefits. Loss rates are what they are & will be what they will be. Loss rates will not get better or worse just because someone assigns a different letter grade to them. If loss rates were in fact better than previously estimated then investors were already reaping the benefits of that fact regardless of any “estimates” & certainly before any of the changes made here…………….. & most importantly at the higher interest rate. To suggest that investors will now benefit additionally going forward by a lowering of those interest rates is nonsense imo. How can the investor benefit by getting less interest? Keep in mind that none of the realities of life will have changed in any way for any of these borrowers except they will now pay $15-16 less on average per month. Will that decrease make an observable decrease in the loss rates of these new loans? Prosper will have you believe that it will & that it will in fact not only negate the roughly 5% drop in the interest rate investors receive on these loans but more than make up for it…………….thereby giving you a better actual return. Come on, really??

I have no idea why Prosper has decided to spin it in this fashion, in effect trying to have it both ways. What’s wrong with just being straight? Just say here is this group of repeat borrowers who have proven with their repayment history that they are a better credit risk than we had initially estimated. Therefore in future we’re raising their credit grade & lowering the interest rates they have to pay. What’s wrong with that? If all the above was correct & true, investors could/would accept that, wouldn’t they? I think they would. So why throw in the……………we’re lowering these rates but you’ll get a higher return BS?

@Peter, I’m glad your strategy is working out for you. I, on the other hand, only have 3 loans currently late. 100% of them are repeat borrowers! Luck of the draw or possibly your strategy of picking repeat borrowers is just superior to mine? I’m hoping the former, but I fear it may be the latter.

@Everyone else, I think the main point is that Prosper has adjusted their risk model to better price loans based on a borrowers profile. If they are correct then they can offer lower rates to certain groups of people because the loss expectations for that group is lower. Basically what this means is the can better price risk. So if their previous model had 50% of the people rated D who actually deserve a D grade loan but also had 30% who should have been rated E and 20% who should have been rated C, removing the 50% who are not D’s would mean that someone who has a higher chance of defaulting would be correctly rated an E and someone who has a lower chance of defaulting would be correctly rated a C. Now you have someone who should be paying a higher interest rate paying a higher interest rate. Would you rather be investing in a D note with an E borrower or a D note with a D borrower? Conversely, you also have someone who should be paying a lower interest rate paying a lower interest. If you look back at when Peter took out a loan, he received an E grade with an E interest rate. Obviously, he could easily get a loan elsewhere for a far lower interest rate and under normal circumstances would not have taken out the loan. Assuming that Prosper now correctly prices his loan, he may be more likely to take out a loan from Prosper than he would have been prior to the changes (i.e. an B borrower would not take out a D grade note since the B borrower could go elsewhere for a lower rate). Of course, this again assumes that their models are getting better and they can price risk more accurately. Like so many other conclusions we seem to come to on this board, we’ll find out when the notes come due.

Great comments everyone. I expected plenty of dissent with this post and you didn’t disappoint.

@Ryan, That is key for Prosper – they want more repeat borrowers and this should encourage them.

@Dan, While it is true that when taken in totality this move is 100% for the borrower but to say it will have no impact on any investor I don’t believe is accurate. Let’s take the casual investor who has a saved search on Prosper that invests in C, D and E grade loans for repeat borrowers. He (or she) doesn’t read the Prosper blog or this blog and has no idea of this change. Now, according to Prosper’s calculations this investor can expect to see an increase in their ROI of approximately 1%.

@Lou, Yes it is marketing, and every smart company puts a positive spin on any change they make if at all possible.

@Charlie, Yes, I think repeat borrowers have been misspriced for some time, but I still think they are a good investment.

@Jason, For investors like us there will be very little if any benefit except for the fact that there will be more supply of repeat borrowers most likely. But I don’t mind shaving a couple of percentage points off my return to be able to put more money to work.

@Dan, I skimmed the article on Saturday morning, and I didn’t refer back to it. The article does seem to focus on lowering interest rates for repeat borrowers. I made the leap that they were updating all their risk models resulting in more accurate pricing across all loans. If they are simply updating it for repeat borrowers by rewarding the repeat borrowers with better rates, then you are correct. The default curve for that subset remains constant while the interest rate is lowered resulting in lower returns for lenders. It does appears as though they are trying to obfuscate the fact that the risk associated with this subset remains constant while the rate is lowered (i.e. the Annual Expected Loss Rate remains constant for this subgroup of loans but they are stating it changes probably based on the rates for the entire new grade to which they are being assigned and not for this specific subset). I’m looking at their pdf, but I would need more time to analyze it (which I do not have at this moment), but it that looks like they recognize the fact that moving these better performing loans to a better grade means that it leaves the remaining loans with the old grade having a higher loss rate and that they are offsetting that with higher pricing (page 7, http://www.prosper.com/prm/pdf/ProsperLossRateandPricingChanges-October2011.pdf). I just don’t have time at the moment to go over it.

On a final note, I do agree with their statement: “We expect that better rates for repeat borrowers will attract more qualified borrowers to Prosper, so that our investors will enjoy more and higher quality loans.” But that can be said of more accurate UW models in general and not just to repeat borrowers.

Peter…………..Whether Prosper “estimates” a higher or lower ROI in no way affects the actual ROI. That’s not really a debatable point simply because it’s an “estimate”. Whether someone erroneously mistakes the “estimate” as being “fact” doesn’t affect the actual ROI that will occur either, though I suppose you could make the case that a casual investor may be persuaded to invest due to a higher estimate.

But the point that I & some others here are making is that there’s just no way to reasonably suggest that one can take a group of borrowers, lower the interest rate they pay to lenders & then suggest that the lenders are somehow going to make more money because of these changes. It just makes no sense. If anything else one can argue (& someone else already has) that these changes will in reality bring down the ROI within this group so that it’s more in line with the average ROI.

@Dan, Obviously an estimated ROI in no way affects an actual ROI. But if a higher estimate turns out to be true then this casual investor we are talking about (the C, D and E repeat borrower investor) will have seen his returns increase. This is despite the fact that the overall ROI has decreased for investors in all repeat borrowers. That is all I am saying.

@Dan, It is probably my fault for not explaining myself fully. Let’s simplify my example to illustrate my point. Let’s say an investor has a saved search and he has been investing in all Prosper 2.0 D-rated repeat borrowers. According to Prosper’s numbers this person has been receiving an ROI of around 12.43% (Lendstats actually estimates this ROI number as higher but let’s stay with Prosper’s numbers).

Now, with this change all of the repeat borrowers that were D-rated are now C-rated and the formally E-rated loans are now D-rated. This casual investor is not aware of this fact and let’s his saved search ride. So he is now investing in what were formally E-rated loans. Prosper estimates this investor will now earn a 13.63% return – 1.2% higher then before. This is understandable because the loans he is now investing in are in fact 1.75% higher in interest than before. But these borrowers he is investing in are happy because their loan rating has changed from E to D and they are paying around 5% less in interest for their loan. So in this situation the borrower wins and the investor wins, even though the ROI for all investors who invest in repeat borrowers has most likely gone down.

Peter, I am trying to find that 13.63% return. What I am seeing is that the expected return per Prosper (http://blog.prosper.com/wp-content/uploads/2011/10/prosper-rating-move.jpg) is actually decreasing from from 12.43% to 12.06%, which they don’t draw attention to. Further, they are attempting to draw our attention to the Return:Risk change from 1.24 to 1.42 stating that the return is higher compared to the risk we are taking. The problem here is that they are using the original expected loss rate of 10.00% to calculate the original 1.24 Return:Risk ration. Looking at page 6 on http://www.prosper.com/prm/pdf/ProsperLossRateandPricingChanges-October2011.pdf they specifically state, “Before, the expectation was a 10% loss rate for a repeat loan from the same borrower, which would assign them to a D rating. Experience now brings expectations down to an 8.5% loss rate, which puts them into the C rating.” This specifically states that the original expected loss rate of 10.00% was incorrect and the newly revised risk rate of 8.5% is the correct loss rate for the original loans. Instead of using that loss rate (which Prosper knows to be true per their pdf file) they chose to remain with the original “expected” loss rate rather than the real (i.e. actual loss rate) of 8.5%. When you use the actual loss rate instead of the 10.00% expected loss rate, the Return:Risk for the “Second Loan (OLD)” is actually 1.46 NOT 1.24. So the Return:Risk ratio actually decreases from 1.46 to 1.42 (i.e. investors are receiving a lower return for the same risk).

Sorry for the long round about way of saying that the risks have not changed, but the return (interest rate) has decreased, but I needed to use that longer explanation of why people on here are upset with the way Prosper is presenting their change of interest as beneficial to investors. For me, the more I look at this the more upset I am with Prosper for trying to put a positive spin on this change for investors. Really, a change from 1.46 to 1.42 isn’t that much worse, but Prosper attempting to hide that and then put a positive spin on it does upset me and sours me a little on them, too.

One of the drawbacks as an investor is that a current (none repeat borrower) is getting an offer to refinance at a lower rate as a repeat borrower. So I loose my high interest loan and have it replaced with a lower interest loan but I have the same risk exposure.

Still it was obvious that repeat borrowers were miss priced before and the previous situation was too good to be true.

Actually, as an addendum, if the expected loss rate was 8.5% rather than 10.00% then the actual return is higher than the 12.43% expected return. This in turn increases the Risk:Return ratio as well, making the 1.46 a low figure for what the actual Risk:Return number should be and upsets me further…if anyone else wants to calculate it to make me further upset go ahead. I might do so later, but not at this time.

Ah, I see where you got the 13.63% return. It looks like you pulled the wrong number. A loan that was under the old calculations a D loan is now a C loan under the new matrix, so the correct expected return is 3 lines up at 12.06%.

I am still having trouble finding the actual returns for this subset of loans. The best I can find is a 15.7% actual return for all D notes per Prosper’s website for “Loans Originated July 2009 – August 2010.” Since this post states that the repeat borrowers are performing better than their peers, I will assume that 15.7% is a low figure for the average actual returns for repeat D loan borrowers. Now using the 8.5% loss rate for this subset of loans, I calculate a 1.847 Return:Risk ratio. With Prosper’s new Return:Risk ratio (given the future expected returns and future expected loss rate) of 1.42, it appears as though lenders are significantly worse off (not better off) than Prosper spins in their blog.

Again, none of this would be an issue with me if Prosper were more upfront about this than having all of us do our DD to find out that the post is, in my opinion, trying to spin this change. I think loans should be competitively and accurately priced. If Prosper were to simply have come out stating that they are overpricing the loans compared to the actual defaults coming in and they are updating the UW models and more accurately pricing the notes, it would not be such a big deal to me. Of course, those of us on the board are probably a minority to those who are actually going through the trouble to figure all this out.

@Roy, I have agreed all along that overall investors will be worse off with this change – but I am ok with that. And I also completely comfortable with the way they chose to spin this. As I said in my comment above, an investor who only invests in “D” repeat loans (and continues to invest in “D” repeat loans) will likely be better off with this change which is the way Prosper chose to spin. I would have done the same thing if I was in their shoes.

As @DuthcinChicago points out previous borrowers have been mispriced for some time now, those of us lucky enough to have invested in a bunch of them are lucky. I still think they will produce outstanding ROI going forward albeit probably a couple of percentage points down from where they have been if you invested in the HR repeat loans as well.

I think I will have to still disagree with you, Peter. Again, using the actual numbers (or as close to them as I can get), a person who invested in any D loan prior to the change would have a return of 15.7% (again, all the information points to it being higher for repeat D loan notes, but I am using this number as a conservative number) and an actual loss rate of 8% giving them a 1.847 Return:Risk ratio. If a person were to invest in the same type of D note (one which would have been previously scored as an E note under the old matrix but a D note under the new matrix), the expected return is the 13.63% as you noted, but the expected loss rate is 10.50% (page 4 of the previously linked to pdf file). This gives a Return:Risk ratio of 1.30 which is even lower than 1.42 if you were to invest in a repeater C note that would have been scored as a D note under the old matrix. Again, I don’t have a big problem with the actual change just with the marketing/presentation.

This doesn’t change the 1.847 Return:Risk ratio, but in my most recent comment I stated 8% instead of the correct 8.5% which my other posts are correctly showing.

Also, just looking at the actual return of 15.7% for D notes compared to the expected to the expected return of D notes under the new matrix of 13.63%, I still find it difficult to state that the average investor in D note repeater loans under the new matrix will be performing better than those who invested in D note repeater loans under the old matrix, let alone any D note regardless of previous loan status.

Peter………..I would have thought that as an advocate of p2p investing, you would be opposed to any change where you believe that “overall investors will be worse off”. Furthermore I’d have thought that you would NOT be comfortable with any type of spin that suggests that the average investor will benefit from these changes, when as you’ve stated, they will not.

@Roy, I understand where you are coming from and I don’t disagree with you. In fact when you look at D repeat borrowers at Lendstats from 7/09 through 12/10 the estimated ROI there is 15.07%. I was commenting on the difference in estimated returns that Prosper states on page 11 of their PDF.

@Dan, I am certainly a p2p lending advocate and I will continue to be that. I am also rooting for Prosper and Lending Club to grow and get bigger. When I wrote this post I knew I was being a bit of a polyanna about this news but I also expected this would spark some interesting debate, which I believe it did.

Look, I realize that this news from Prosper is going to reduce the ROI for most investors but is that necessarily a bad thing? If all you care about is your own personal return then, yes, this is not good news. But if this change helps grow their business and brings more repeat borrowers on to the platform then I will be all for it.

I am naturally a glass half-full guy and I probably put too much of a positive spin on things some time. I have always done that and probably will continue to do so but thankfully I have people like you, Roy, and many others here, who can keep me in line.

You know I’m not even sure that Prosper will get many more repeat customers from this move. Think about it…………a 5 year old company that deals in 3 year average loans where 34% of new loans issued this year are to repeat borrowers already. That’s a pretty high percentage number for a young loan company. I mean it’s not like they’re selling groceries here. How many more repeaters do they think they can get? Anyways……………………

@Peter, Yeah, their marketing makes it look like it’s a good thing for the investor because the expected return is going up. If there were no historical data for either population, then you can say that returns look like they will be better for investors under the new pricing matrix. But when you take a look at the actual returns that investors have been receiving and compare that to the expected returns they will be receiving under the new matrix, investors returns will actually be decreasing for this subset of loans. And that is where I have a beef with Prosper.

Where we do agree, Peter, (and what I have attempted to make abundantly clear) is that I believe more accurate and competitive pricing of loans will benefit everyone–Prosper, lenders and borrowers–even when the returns for a specific subset of the loan population decreases. When I first skimmed the blog post on Saturday morning, that is what I initially thought the post was about. It wasn’t until others on your blog brought it to my attention that the post was attempting to (in my opinion) spin this change and mislead investors into believing Prosper’s new matrix for repeat borrowers would benefit investors directly by increasing returns for this specific subset that I really took a look into. So much for me giving Prosper the benefit of the doubt when it comes to their marketing.

Look I think I speak for everybody here in saying that we all want Prosper to succeed. Even those of us who may not be investors there wouldn’t enjoy the fallout that would likely occur if they don’t succeed.

I just think that Prosper doesn’t do itself any favors being so creative with their facts when they don’t need to be. Situations like this just further reinforce the feeling that every single word, every single number needs to be fact checked & put through a strong spin filter, & that is the main reason why I’ve never recommended any investor to Prosper.

What is perplexing is that returns in the 8-9% range are almost universally characterized as being very good to excellent in almost all market environments, & that is what Prosper appears to be producing these days. So that’s plenty, you don’t need to spin or exaggerate if you can produce those types of numbers long term.

@Roy, Prosper (like most companies) put a marketing spin on the changes they do. I think that is understandable. I was simply making the point that what they are saying may well turn out to be true for a subset of investors but it is highly likely that most investors will see reduced returns because of this.

@Dan, Good question about the percentages here. I am not sure what their goal is but 34% seems like a high number. It could be they just want to maintain that number going forward and as they add more new borrowers on to the platform they are going to need more repeat borrowers as well. I doubt they would ever be able to (or would want to) reach 50% for repeat borrowers.

As for the spin, I think Prosper are really trying to prove they are the best alternative when it comes to p2p lending. Lending Club is a formidable competitor and so they always want to be portraying their changes in a positive light.

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